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Financial Debate Renews Scrutiny on Banks’ Size

Senators Edward E. Kaufman Jr., left, and Carl Levin during a financial hearing last week. Credit
Stephen Crowley/The New York Times

WASHINGTON — One question has vexed the Obama administration and Congress since the start of the financial crisis: how to prevent big bank bailouts.

In the last year and a half, the largest financial institutions have only grown bigger, mainly as a result of government-brokered mergers. They now enjoy borrowing at significantly lower rates than their smaller competitors, a result of the bond markets’ implicit assumption that the giant banks are “too big to fail.”

In the sweeping legislation before the Senate, there is no attempt to break up big banks as a means of creating a less risky financial system. Treasury Department and Federal Reserve officials have rejected calls for doing so, saying bank size alone is not the most important threat.

Instead, the bill directs regulators to compel the largest banks to hold more capital as a cushion against losses. It sets up a procedure intended to allow big banks to fail, with the cost borne not by taxpayers but by the biggest financial institutions.

As the debate over the regulatory overhaul heated up this week, a populist minority in both Congress and the Fed requested a revisit to the size issue. They would like to go beyond a provision in the bill, suggested by Paul A. Volcker, the former Fed chairman, and supported by President Obama, that would seek to keep banks from growing any larger but not force any to shrink.

“By splitting up these megabanks, we by definition will make them smaller, safer and more manageable,” Senator Edward E. Kaufman Jr., Democrat of Delaware, said in a speech Tuesday.

The president of the Federal Reserve Bank of Dallas, Richard W. Fisher, broke ranks with most of his colleagues within the central bank last week, declaring, “The disagreeable but sound thing to do regarding institutions that are too big to fail is to dismantle them over time into institutions that can be prudently managed and regulated across borders.”

There also has been concern about the size of banks from Republicans who believe in free-market principles. Several senators from the South and West — Richard C. Shelby of Alabama, Johnny Isakson of Georgia, John Cornyn of Texas and John McCain of Arizona — have expressed a desire to revisit the 1999 repeal of the Glass-Steagall Act, the Depression-era law that separated commercial and investment banking.

Alan Greenspan, the former Fed chairman, has entertained the idea of splitting up the banks but has stopped short of advocating it.

“If they’re too big to fail, they’re too big,” he said in an October speech.

He added: “In 1911, we broke up Standard Oil. So what happened? The individual parts became more valuable than the whole. Maybe that’s what we need.”

In January, the White House embraced a proposal by Mr. Volcker that would ban banks that take customer deposits from running their own proprietary trading operations, or making market bets with their own money. It would also limit the share of all financial liabilities that any one institution can hold — besides deposits — but it would be up to regulators to set the limit.

A federal law enacted in 1994 already addresses size by restricting any bank from holding more than 10 percent of the nation’s deposits, although several of the largest banks have been granted waivers from that requirement or used loopholes to evade its intent.

The Volcker proposal resembled an amendment by Representative Paul E. Kanjorski, Democrat of Pennsylvania, that would let regulators dismantle financial companies so large, interconnected or risky that their failure would jeopardize the entire system. The amendment was part of a regulatory overhaul that the House adopted in December, largely along party lines, and is also in the Senate version in a modified form.

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At a hearing on Tuesday about the bankruptcy of Lehman Brothers, which caused credit markets to seize up in September 2008, the Fed chairman, Ben S. Bernanke, reiterated that his preference was to limit the risky behavior of banks rather than break them up.

“Through capital, through restrictions in activities, through liquidity requirements, through executive compensation, through a whole variety of mechanisms, it’s important that we limit excessive risk-taking, particularly when the losses are effectively borne by the taxpayer,” Mr. Bernanke said.

But when Mr. Kanjorski pressed him on whether regulators should be allowed to break up big banks, he replied, “It’s something that would be, on the whole, constructive.”

Representative Brad Sherman, Democrat of California, added: “We should go further and not just allow, but require, regulators to break up firms that have reached a certain size.”

What is not in doubt is that the crisis increased the size and importance of the six largest banks: Bank of America, Citigroup, JPMorgan Chase, Wells Fargo, Goldman Sachs and Morgan Stanley.

In 1995, the assets of the six largest banks totaled 17 percent of the nation’s gross domestic product. Now they have assets amounting to 63 percent of G.D.P. Measured another way, the share of all banking industry assets held by the top 10 banks rose to 58 percent last year, from 44 percent in 2000 and 24 percent in 1990.

Gary H. Stern, the co-author of “Too Big to Fail: The Hazards of Bank Bailouts,” said policy makers largely ignored the warnings contained in the title when the Brookings Institution published the book in 2004.

Mr. Stern, who retired last year as president of the Minneapolis Fed, is lukewarm about the bill. “It tries to address the problem but it’s half a loaf at best,” he said. “It doesn’t address the incentives that gave rise to the problems in the first place.”

In Mr. Stern’s view, ending “Too Big to Fail” should subject uninsured creditors — bondholders — to losses if the bank fails. Without that fear, he said, unsecured creditors will not exert discipline on the banks by monitoring their risk-taking and pricing their loans appropriately. Mr. Stern said the bill in the Senate is vague about how such creditors would be treated if the government were to seize and dismantle a failing bank.

Simon Johnson, an M.I.T. professor, has been leading the intellectual charge to break up banks. In his book “13 Bankers,” he urged that no financial institution be permitted to control more than 4 percent of G.D.P. and no investment bank more than 2 percent. All six of the big financial institutions exceed those limits.

Forbidding taxpayer bailouts, as the Senate bill proposes, is worth little more than the paper it is on, Mr. Johnson argues. “When push comes to shove, will the government save these guys?” he asked. “I don’t know anybody who doesn’t think they’d save Goldman if Goldman were to suddenly run into trouble.”

A version of this article appears in print on April 21, 2010, on Page A1 of the New York edition with the headline: Financial Debate Renews Scrutiny On Size of Banks. Order Reprints|Today's Paper|Subscribe